Welcome to Day 10
Principles of
Microeconomics
Price elasticity is the ratio of the percent
change in quantity demanded to the
percent change in price.
Elasticity of demand = percent change in
quantity demanded divided by percent
change in price.
Ed = %Qd
% P
So a t-shirt shop notices that when
they raise their price by 5%, they
lose 10% of their customers. What
is their elasticity of demand?
-10% = -2
5%
What does the -2 mean?
For every 1 percent they raise their
price, their sales drop by 2%.
The elasticity of demand number
always means that for every 1%
they raise their price, their sales
drop by X%
Another store checks their data
and sees when they raise their
price by 10%, they lose 5% of their
sales. What is their elasticity of
demand?
-5% = -0.5
10%
For every 1% they raise their price,
they lose 0.5% of their sales.
What if the stores lowered their price?
Then a store with an elasticity of -2
should gain 2% in sales for every 1%
drop in price. A store with an elasticity
of -0.5 should gain 0.5% more sales
with every 1 percent drop in price.
Unfortunately, the data does not
usually come in percentage terms.
Usually you know the starting and
ending prices, and the starting and
ending quantities, and have to
convert these to percentages.
Here’s how to do that.
%Qd = (Q2-Q1)/[(Q1+Q2)/2]
%P = (P2-P1)/[(P1+P2)/2]
So the elasticity formula in all its
glory is
Ed = (Q2-Q1)/[(Q1+Q2)/2]
(P2-P1)/[(P1+P2)/2]
The textbook writes it this way
Q / Q
eD 
P / P
Notice that we are calculating percentage
changes in an unusual way. Usually, you
would just divide the change by the
starting value, not the average of the
starting and ending value.
By doing it this way, we get the same
elasticity answer if the price goes up from
$10 to $12 or down from $12 to $10.
The own price elasticity number
will always be negative by the
math, but it is common to drop the
negative sign and write it as its
absolute value. So -2 becomes 2.
What is the range of possible own
price elasticities?
0
Ed < 1 then
Inelastic Demand
Ed > 1 then
Elastic Demand
Ed = 1 then Unit
1
Elastic Demand
8
Total Revenue for a store is
TR = P x Q
Imagine a store with a very
inelastic demand, say 0.3 If they
raise their price 10%, their sales
drop by 3%. Does their revenue go
up or down?
TR ? = P 10% x Q 3%
TR goes up.
Whenever the elasticity is below 1, the
percent drop in purchases is always
less than the percent rise in price and
revenue always rises when price rises.
What if the elasticity is greater than
one? Then the percentage drop in
sales is always greater than the
percent rise in price and the revenue
always fall.
TR ? = P 3% x Q 10%
TR goes down.
Inelastic Demand
Raise price
revenue goes up.
Lower price
revenue goes down.
Elastic Demand
Raise price
revenue goes down.
Lower price
revenue goes up.
And if the demand is unit elastic?
Then the percentage change in price
equals the percentage change in sales,
and revenue remains unchanged.
Unit Elastic Demand (Ed = 1)
Raise price
revenue stays the same.
Lower price
revenue stays the same.
What happens if zero customers stop
buying when the price rises?
Ed = %Qd
% P
Ed = 0.
This is called perfectly inelastic demand.
Note that an Ed = 0 does not mean
the store has 0 customers, it
means it loses 0 customers then it
raises its price.
And what if the store loses every
customer when it raises its price the
tiniest possible amount?
Ed = %Qd
% P
As %P goes to 0, %Qd stays constant.
This fraction is going to infinity.
Perfectly
Inelastic
Demand Curve
Perfectly
Elastic
Demand Curve
What determines if the elasticity is
high or low?
1) Number and closeness of
substitutes.
2) Percentage of budget spent on
the good.
3) Time.
1) Number and closeness of
substitutes.
The more and better substitutes
available for a good, the more
consumers buy these substitutes in
place of the good when the price
of the good rises.
Good substitutes
Poor substitutes
high elasticity
low elasticity
Tell me some high and low
elasticity items.
2) The percentage of your budget spent on
the good.
When the price of the car you are thinking
of buying doubles, you are more likely to
back off buying it than when the price of a
candy bar doubles.
The greater the percentage of your budget
spent on the good, the higher its elasticity
of demand.
3) Time
The more time you have to
respond, the higher the elasticity
of demand.
What can you do if the price of gas
rises?
The textbook tells us that the
short-run elasticity of demand for
oil in the United States is .06, but
the long-run elasticity is .45
Reviewing the 3 factors that
determine elasticity of demand.
1) Number and closeness of
substitutes.
2) Percentage of budget spent on
the good.
3) Time.
What we learned today.
1. What own price elasticity is and
how to calculate it.
2. What inelastic and elastic demand
mean and how they affect revenue
when price rises.
Welcome to Day 11
Principles of
Microeconomics
What we learned yesterday.
1. What own price elasticity is and
how to calculate it.
2. What inelastic and elastic demand
mean and how they affect revenue
when price rises.
Income elasticity of demand is the
percentage change in quantity
demanded at a specific price divided
by the percentage change in income
that produced the demand change, all
other things unchanged.
Ei = %D
D = Demand
% I
I = Income
What does the income elasticity
number tell you?
It is the percent change in
purchases if there is a 1 percent
rise in income. For example, an
answer of 0.7 means for every 1%
rise in income, people buy 0.7
percent more of the good.
When the income elasticity is positive,
that means people buy more of the
good when their income goes up or
less when their income goes down. In
other words, a normal good.
When the income elasticity is negative,
people buy less when their income
goes up, in other words, an inferior
good.
Cross price elasticity of demand is the
percentage change in the quantity
demanded of one good or service at a
specific price divided by the
percentage change in the price of a
related good or service.
EX,Y = %Dx
% Py
Remember how to find the
percentage change in X.
It is the change in X divided by the
average of the starting and ending
quantities of X. And don’t forget to
check for the sign.
Cross-price elasticity is positive
when the two goods are
substitutes.
It is negative when the two goods
are complements.
Price elasticity of supply is the
ratio of the percentage change in
quantity supplied of a good or
service to the percentage change
in its price, all other things
unchanged.
%
change
in
quan
sup
e

s
%
chang
in
pric
The terminology from the elasticity
of demand transfers over to the
elasticity of supply.
Es > 1 is Elastic Supply
Es < 1 is Inelastic Supply
Es = 0 is Perfectly Inelastic Supply
Es = Infinity is Perfectly Elastic
Supply.
Supply Curves and Their Price
Elasticities
The more time suppliers have to
build more factories, the greater
the increase in the amount of the
good will be in response to a given
higher price.
Which supply curve has
the larger elasticity?
S1
P2
S2
P1
Q Cars
Elasticity and the War on Drugs
How can we spend so much money
and manpower and drugs still be so
readily available?
http://www.drugsense.org/cms/wodclock
How do we represent the war on drugs in
a supply and demand diagram?
Is the elasticity of demand for most illegal
drugs going to be high or low?
Does cocaine have good substitutes or
few substitutes?
D1 is low elasticity.
D2 is high elasticity.
$70.00
$60.00
$50.00
$40.00
P2
P1
$30.00
$20.00
D2
$10.00
D1
$0.00
0
100000
Q2B
Q2AQ1
200000
300000
How much cocaine has been destroyed?
What is the drop in usage?
$70.00
$60.00
S2
$50.00
P2
S1
$40.00
$30.00
P1
$20.00
$10.00
D
$0.00
0
100000
Q2 Q1
200000
300000
Q1 to Q2 is the drop in usage = 25,000
Amount destroyed = 125,000
$70.00
$60.00
S2
$50.00
P2
Amt.
Destroyed
$40.00
S1
$30.00
P1
$20.00
$10.00
D
$0.00
0
100000
Q2 Q1
200000
300000
So what has happened? Used to
be 150,000 made and bought for
20 bucks. Now 250,000 is made,
half is destroyed, and 125,000 is
bought for $40.
The main effect of destroying drugs
in this model is that more is made.
What is the elasticity of cocaine in
this model? Q1-Q2/[(Q1+Q2)/2]
divided by P2-P1/[(P1+P2)/2] is
(25,000/ 137,500)/(20/30)
= .18/.67 = .2
What if the elasticity is high?
Q1 to Q2 is the drop in usage = 60,000
Amount destroyed = 90,000
$60.00
S2
$50.00
S1
$40.00
P2
P1
Amt.
Destroyed
$30.00
$20.00
D
$10.00
$0.00
0
100000
Q2
200000
Q1
300000
What is the elasticity of cocaine
now?
Q1-Q2/[(Q1+Q2)/2] divided by P2P1/[(P1+P2)/2] is
(60,000/120,000)/(6/23)
= .5/.26 = 1.92
Notice how much more the price
rises when the elasticity is low.
What are some side effects of
cocaine prices going high?
Now let’s look at the effect of
government subsidized student
loans.
Students are given $300,000,000 to go to
college (doubling current tuition spending)
Tuition
$9,000.00
$8,000.00
S
$7,000.00
$6,000.00
$5,000.00
$4,000.00
D2
$3,000.00
$2,000.00
D1
$1,000.00
$0.00
0
50000
100000
150000
200000
250000
Number Students
Number of students rises from
100,000 to 130,000. Tuition rises
from $3,000 to $5,600.
Everyone gets to pay the higher
tuition, not just the additional
students.
And don’t forget, these are loans,
so you still have to pay the money
back.
So who is helped more by
government guaranteed loans?
The students … or the colleges and
banks?
And this result is because of elasticity of
supply. What if elasticity of supply is high?
$8,000.00
$7,000.00
$6,000.00
$5,000.00
S
$4,000.00
$3,000.00
D2
$2,000.00
D1
$1,000.00
$0.00
0
50000
100000
150000
200000
250000
What we learned today.
1. What income elasticity and cross
price elasticity are.
2. How elasticity of demand
determine the effectiveness of the
war on drugs and student loan
programs.
Welcome to Day 12
Principles of
Microeconomics
What we learned yesterday.
1. What income elasticity and cross
price elasticity are.
2. How elasticity of demand
determine the effectiveness of the
war on drugs and student loan
programs.
We’re skipping chapters 6 and 7 for
now, but we will come back to ch.
6 at the end of this unit and ch. 7
at the end of the class.
Instead we’re moving to chapter 8
to talk about production and cost.
We’ve already seen in our elasticity
of supply discussion that time
matters for how much is produced.
Two Time Frames
Short-Run: Some inputs are fixed
Long-Run: All inputs are variable
Marginal Product of Labor (MPL) is
the increase in total output gained
by adding one more worker.
Q/L
N
0
Q
0
MPL
20
1
20
30
2
50
25
3
75
10
4
85
N
0
Q
0
MPL
20
1
20
30
2
50
25
3
75
10
4
85
Why would
MPL be rising?
Specialization of Labor
1) Take advantage of natural
abilities.
2) More practice and training at
specific jobs.
3) Less time lost walking between
jobs.
N
0
Q
0
MPL
20
1
20
30
2
50
25
3
75
10
4
85
Specialization
of Labor
Region
N
0
Q
0
MPL
20
1
20
30
2
50
25
3
75
10
4
Specialization
of Labor
Region
85
Why would
MPL be
falling?
Diminishing Returns
As more variable factors are added
to work with a fixed factor,
eventually output rises at a
diminishing rate.
N
0
Q
0
MPL
20
1
20
30
2
50
25
3
75
10
4
Specialization
of Labor
Region
85
Diminishing
Marginal
Returns Region
Productivity of Labor Measured in MPL
Bushels of Wheat
35
Spec. of
30
Labor
Reg.
25
Dim. Mar.
Ret. Reg.
20
15
10
5
0
0
1
2
3
Number of Workers
4
5
Now that we know what MPL is,
here is a new statistic for you.
Average Product of Labor (APL) =
Q/N
Average-Marginal Rule:
When the marginal is above
the average, the average rises;
when the marginal is below the
averge, the average fall.
N
0
Q
0
1
20
2
50
3
75
4
85
MPL APL
0
20
20
30
25
25
25
10
21.25
Marginal and Average Product of Labor
on the same graph.
35
Bushels of Wheat
30
APL
25
20
15
MPL
10
5
0
0
1
2
3
Number of Workers
4
5
Marginal and Average Product of Labor
on the same graph.
35
Bushels of Wheat
30
APL
25
20
15
MPL
S.o.L.
Region
10
5
D.M.R. Region
0
0
1
2
3
Number of Workers
4
5
Output
MPL
APL
Number Workers
What we learned today.
1. What marginal product of labor is.
2. How specialization of labor and
diminishing marginal returns
determine if MPL is rising or falling.
3. The average-marginal rule and
how to graph MPL and APL together.
Welcome to Day 13
Principles of
Microeconomics
What we learned yesterday.
1. What marginal product of labor is.
2. How specialization of labor and
diminishing marginal returns
determine if MPL is rising or falling.
3. The average-marginal rule and
how to graph MPL and APL together.
I told you the productivity story
just so I can tell you the cost story.
Fixed Costs (don’t change as production
varies):
Lease Payments
Interest on Loans
Some Insurance
Variable Costs (do change as production
varies):
Labor
Supply
Electricity
Q
0
1
2
3
4
5
TFC
100
100
100
100
100
100
TVC
0
20
35
60
100
160
TC MC ATC
100 --120 20 120
135 15 67.5
160 25 53.3
200 40 50
260 60 52
If workers cost $10 each, how
many workers did the firm hire
to build 1 radio?
How about 2 radios?
Why does it take 2 full workers to
make the first radio, but only another
1.5 to make the second radio?
The workers must be getting more
productive. Why would that be?
Why does it take 2 full workers to
make the first radio, but only another
1.5 to make the second radio?
The workers must be getting more
productive. Why would that be?
Specialization of Labor
Why does it take 4 workers to
make radio 4, but 6 workers to
make radio 5?
Why does it take 4 workers to
make radio 4, but 6 workers to
make radio 5?
Diminishing Marginal Returns
Q TFC TVC TC MC ATC
0 100 0 100 --1 100 20 120 20 120
2 100 35 135 15 67.5
3 100 60 160 25 53.3
4 100 100 200 40 50
5 100 160 260 60 52
Above the green line is SoL.
Below is DMR.
Marginal Cost and Average Total Cost on
the same graph.
140
Cost in Dollars
120
ATC
100
80
60
40
MC
20
0
0
2
4
Output
6
8
Marginal Cost and Average Total Cost
on the same graph.
Dollars
Fixed
Cost
MC
ATC
Specialization Diminishing
Output
of labor
Marginal Returns
In the short-run, the size of the
factory is fixed.
In the long-run, the size of the
factory can be varied.
The LRATC is made up of segments of
the various possible SRATC curves.
Economies of Scale - LRATC is falling as
you produce more in a larger factory.
Constant returns to Scale - LRATC is
staying the same as you produce more
in a larger factory.
Diseconomies of Scale - LRATC is rising
as you produce more in a larger factory
Why Economies
of Scale?
1) Specialization
of Labor
2) Mass
Production
Techniques –
Assembly Lines
Why Diseconomies of Scale?
Contr
1) Command and
Control
Problems
2) Law of Increasing
Opportunity Cost
Problems
Would you always want to produce
in constant returns to scale since
that is the lowest cost of
production area?
Would you always want to produce
in constant returns to scale since
that is the lowest cost of
production area?
No! How many
customers you
have and how
much they are
willing to pay
matters also.
Alright, so you learned all this
about productivity and cost. What
is the business actually going to
do?
For that, we have to bring in the
customers.
Businesses operate in different
environments, called market
structures.
There are 4 market structures.
Each market structure is defined
by:
1) How many firms sell in it.
2) How close the firms products
are to each other.
3) How easy it is to get into or out
of the market.
The first market structure is
“Perfect Competition”
1) Many sellers and buyers.
2) Firms sell identical goods.
3) There is easy entry/exit.
Because there are many firms
selling identical products, the sales
price is the same for all firms.
These firms are called Price Takers.
Perfect Competition examples are:
1) Small farms.
2) Stockbrokers selling identical
stock.
3) Miners.
4) Fishermen
A small wheat farmer has a
demand curve that looks like this:
P
Demand
Curve
$5.98
Q
He’s not worried that he will
produce so much wheat he will
drive the world price of wheat
down.
The world demand curve for wheat
is still downward sloping, but he is
too small to make any difference.
Just like you buying potato chips.
What we learned today.
1. How to graph MC and ATC.
2. What causes economies and
diseconomies of scale.
3. What perfect competition is
and what its demand curve looks
like.
Welcome to Day 14
Principles of
Microeconomics
What we learned yesterday.
1. How to graph MC and ATC.
2. What causes economies and
diseconomies of scale.
3. What perfect competition is and
what its demand curve looks like.
Marginal Revenue is the increase in
total revenue gained with each
additional sale.
It is a before cost is taken out
number.
For firms in perfect competition,
marginal revenue = price.
A small wheat farmer has a
marginal revenue curve that looks
like this:
P
$5.98
Marginal
Demand = Revenue
Curve
Curve
Q
The farmer does not get to pick his
price, but he does get to pick his
quantity of wheat grown. He will
do what makes him the most
money.
Q
0
1
2
3
4
TR
0
10
20
30
40
TC π Price=$10
2 -2 TR = P x Q
10 0 π = Profit
16 4 TR = Total
25 5
Revenue
37 3 TC = Total
Cost
Q
0
1
2
3
4
TR
0
10
20
30
40
TC
2
10
16
25
37
π MR MC
-2 -- -0 10 8
4 10 6
5 10 9
3 10 12
To maximize profit, produce the
wheat that has MR>MC and
don’t produce the wheat that
has MC>MR.
Don’t sell any
lemonade that
costs more than
10 cents to make.
If you can produce fractions rather
than just integers, then produce
the level of output where MR=MC.
This is what the textbook calls the
marginal decision rule.
Just because you follow the
marginal decision rule doesn’t
mean you necessarily make a
positive profit. Sometimes the
best you can do is to lose the least.
Q
0
1
2
3
4
TR
0
10
20
30
40
TC
20
28
34
43
55
π MR
-20 --18 10
-14 10
-13 10
-15 10
MC
-8
6
9
12
What should you do here?
Note that you can’t avoid a loss by
shutting down. If you shut down,
you lose fixed cost.
Is there a way to know if you are
making a profit or losing money
just using the price and the ATC of
production?
TR = P x Q
TC = ATC x Q
TR = P x Q
TC = ATC x Q
The Q’s will be the same for both
equations. So if P>ATC, this firm is
making money. If P<ATC, this firm
is losing money.
So how do you graph this all out?
First, the marginal decision rule:
produce the quantity where
MR = MC
Produce at Qπ to maximize profit.
14
Cost in Dollars
12
10
MR
8
6
MC
4
2
0
0
1
2
3
Output
Qπ
4
5
MC
P
Pπ
MR
Q
Qπ
Here, MC intersects MR twice. Always
use the 2nd point of interception.
MR, MC, and P are not enough to
know if you are making a positive
profit. As fixed costs rise, these
numbers do not change, yet your
profit is falling. You need to add
ATC.
MC
P
Pπ
ATC
MR
Q
Qπ
Here we have profit because P>ATC.
MC
P
Pπ
ATC
MR
Q
Qπ
Here we have a loss because ATC>P.
What we learned today.
1. What MR is and to produce the
quantity where MR = MC.
2. The firm makes a profit when P>ATC
3. How to graph the Q and P of a
business and if they are making a
profit.
Welcome to Day 15
Principles of
Microeconomics
What we learned yesterday.
1. What MR is and to produce the
quantity where MR = MC.
2. The firm makes a profit when P>ATC
3. How to graph the Q and P of a
business and if they are making a
profit.
When should a firm just give up
and shut-down?
When its loss from operating is
greater than its fixed cost.
Firm 1
TR
$400
TFC $100
TVC $395
TC
$495
Profit $-95
Firm 2
$400
$100
$405
$505
$-105
What should each firm do?
Keep operating when TR>TVC.
TR = P x Q
TVC = AVC xQ
Keep operating when P>AVC
Shutdown when P<AVC
P = AVC is the shutdown price.
MC
P
P1
MR
Q
How much will this firm produce at P1?
P
P2
P1
P3
MC
MR
Q
Q1
What about at P2 and P3?
P
P2
P1
P3
MC
MR2
MR1
MR3
Q3 Q1 Q2 Q
We have marked 3 points on the
firms supply curve.
Supply Curve
P
P2
P1
P3=PS
Q3 Q1 Q2 Q
The firm’s marginal cost curve is its supply
curve down to the Shutdown Price (PS)
The market supply curve is all the
individual supply curves added together.
P
Individual
firm supply
curves
Market
Supply
Curve
Q
Now we add the demand curve and we
get where the market price comes from
P
S
PE
D
Q
The market price for wheat is the
price such that each farm, in response
to that price, wants to grow an
amount of wheat which, when all the
farms are added together, equals the
amount of wheat that customers
want to buy at that price.
This is what chapter 3 said, also.
Now let’s talk about the long-run,
so enough time goes by that new
farms can enter the market.
Before we do so, let’s be a bit more
exact about what we mean by cost
and profit.
Explicit Cost is actual money paid
out.
Implicit Cost is the value of
resources used for which no
money is paid. For example: time
and already owned land.
Accounting profit is Total Revenue
minus Explicit Cost.
Economic Profit is Total Revenue
minus both Explicit and Implicit
Cost.
The economic profit of a choice can
also be understood as how much more
you make doing this choice than the
next best choice.
You are offered $100 to work all day
on project A and $60 to work all day
on project B. What is your economic
profit of choosing A?
Suppose woman A and woman B
want to start two similar businesses.
Woman A has an $80,000 job she
would have to quit to run her
business, but woman B is
unemployed and we count her time
as having 0 value. How does this
affect their accounting and
economic profits?
Woman A
Total Revenue $100,000
Explicit Cost
$60,000
Accounting Profit $40,000
Implicit Cost
$80,000
Economic Profit -$40,000
Woman B
$100,000
$60,000
$40,000
$0
$40,000
Economic profit is a better
predictor of behavior. We would
predict woman A will not start this
business and woman B will.
So now enough time goes by for
new wheat farms to open up.
When will new farms be started?
When wheat farms are making
money, that is, have a positive
economic profit.
How long will the new farms keep
coming in? Remember, entry is
easy.
Till profits go to zero.
If profits are negative (in other
words, losses), then farms will
leave in the long-run until profits
are zero.
So no matter where you start,
profits in the long-run go to zero
because of easy entry/exit.
So what does the long-run
equilibrium look like? Let’s think
about how the long-run responds to
an increase in demand.
Start at a long-run equilibrium with
profits for the typical wheat farm at
$0.
MC
ATC
P
P1
MR=P
Q
How much will this firm produce at P1?
Now there is an increase in market
demand and the price rises to P2 in the
short-run.
P
Sshort-run
P2
P1
D1
D2
Q
P
P2
P1
MC
ATC
MR2=P2
MR1=P1
Q
This firm is now making a profit. This
attracts entry.
P
P2
P1
MC
ATC
MR2=P2
MR1=P1
Q
How far will the price have to fall until
profit is back to zero?
There has to be a new equilibrium back at
P1. For this to happen, the long-run
supply curve has to be flat.
P
Sshort-run
P2
P1=P3
D1
Q 1 Q2
Q3
D2
SLong-run
Q
P
P2
P1=P3
MC
ATC
MR2=P2
MR1=P1
MR3=P3
Q
And profits are back to zero. BTW, this farm is
back to producing where it started, so where
is all the additional wheat coming from?
What we learned today.
1. When a firm losing money should
shutdown (P<AVC or TR<TVC).
2. How firm’s supply curve is its MC
curve and market equilibrium.
3. In the long-run, profits go to zero.
4. The long-run equilibrium for the
market with perfect competition.
Welcome to Day 16
Principles of
Microeconomics
What we learned yesterday.
1. When a firm losing money should
shutdown (P<AVC or TR<TVC).
2. How firm’s supply curve is its MC
curve and market equilibrium.
3. In the long-run, profits go to zero.
4. The long-run equilibrium for the
market with perfect competition.
But I fear we have proven too much. It
looks like in the long-run, price always
goes back to where it started, and I
don’t believe this.
P
P2
P1
MC
ATC
MR2=P2
MR1=P1
Q
How can we get back to zero profits as
new firms come in with the price ending
up higher than P1?
P
P3
P2
P1
MC
ATC2
ATC1
MR2=P2
MR1=P1
Q
That’s right. If ATC rises as new firms
enter the market.
So now P3 will be higher than P1 when
ATC rises as new firms enter.
P
P2
P3
P1
Sshort-run
SLong-run
D1
Q1 Q2 Q3
D2
Q
This case of rising ATC as new firms
enter is called an “Increasing Cost
Industry”.
The first case where ATC stayed
constant is called a “Constant Cost
Industry”.
Which case seems more likely?
Could it even be possible that as
more firms enter the market, the
ATC falls?
Think about what happens if wheat
farms need tractors, and tractors
are made with economies of scale.
For this “Decreasing Cost Industry”,
the long-run price P3 will be lower
than the starting price P1 if there is
an increase in demand. This
means there must be a downward
sloping long-run supply curve.
Now P3 is less than P1. And increase
in demand has lead to a lower price.
P
Sshort-run
P2
P1
P3
SLong-run
Q1 Q2
D1
Q3
D2
Q
Let’s review and simplify.
Increasing Cost Industry.
LRS slopes up.
P
SLong-run
P2
P1
D1
Q1
Q2
D2
Q
Constant Cost Industry.
LRS slopes straight across.
P
SLong-run
P1=P2
D1
Q1
Q2
D2
Q
Decreasing Cost Industry
LRS slopes down.
P
P1
P2
SLong-run
D1
D2
Q1
Q2
Q
Where does all this leave the law of
supply?
It is still true that short-run supply
curves always slope up. But now this
is primarily because of diminishing
marginal returns rather than the next
worker getting worse.
In the long-run, supply curves usually
slope up as more resources are used
and the workers get worse; but it is
possible for the supply curve to slope
down if significant inputs are made
with economies of scale. As we add
more complexity to the model, our
previously simple answers grow more
complex.
Now, back to
Chapter 6
Our goal is to answer the 3
fundamental questions well.
1) What to produce?
What people want.
2) How to make it?
Produce efficiently.
3) Who gets what is produced?
People who value it.
An economy that does these things
is operating efficiently.
Efficient
The allocation of resources when
the net benefits of all economic
activities are maximized.
An economy that is operating
efficiently has both:
1) Efficient production
2) Efficient allocation of goods.
Will a market economy do these
things?
How does a business make money?
Producing a lot of what people
want the most and selling it.
The better a business correctly
estimates what its customers
value, and makes a lot of those
things, the higher its profit.
And of course, we want the
economy to be able to adjust to
changing circumstances. Will a
market economy do that?
Rainy Winter Increases Demand
P
$16.00
$14.00
S
$12.00
P2 $10.00
P1 $8.00
D2
$6.00
$4.00
D1
$2.00
$0.00
0
100000
Q1 Q2
200000
300000
Q
Can a command economy do this?
The incentive problem and the
information problem.
The Incentive Problem
What does an umbrella businessman get
if he gets umbrellas quickly out to a
rainy area?
What does the 2nd undersecretary of
umbrellas in Washington get if he gets
umbrellas quickly out to a rainy area?
The Information Problem
How does the 2nd Undersecretary of
Umbrellas know we need more
umbrellas in Bakersfield?
How do private business owners of
umbrella companies know?
Every time you go shopping, it is
a transfer of information fest!!!
You are letting sellers know
what you want.
Sellers are letting you know
what they can make at what
cost.
The Invisible Hand
Adam Smith – 1776
The Wealth of Nations
Because trades are
voluntary, in helping yourself, you help
others also.
The way for the businessman to
make money is to most effectively
serve his customers.
In doing what is best for him, he is
being lead, as if by an “invisible
hand” to help society.
What we learned today.
1. Increasing, constant, and decreasing cost
industries and the slope of the long-run
supply curve.
2. Operating Efficiency, which is broader
than production efficiency.
3. How the market economy solves the
incentive and information problems –
“The Invisible Hand”.
Welcome to Day 17
Principles of
Microeconomics
What we learned yesterday.
1. Increasing, constant, and decreasing cost
industries and the slope of the long-run
supply curve.
2. Operating Efficiency, which is broader
than production efficiency.
3. How the market economy solves the
incentive and information problems –
“The Invisible Hand”.
So what can go
wrong?
Market Failure - The failure of
private decisions in the
marketplace to achieve an efficient
allocation of scarce resources.
In other words, we are making too
much or too little of something
because of a failure to properly take
account of its benefits and costs.
What markets does the government
heavily regulate in the U.S.
economy?
Externalities – an action taken by a
person or firm that imposes
benefits or costs outside of any
market exchange.
We’ve seen these pictures earlier
this semester, but we didn’t have a
name for what they were yet. Now
we do.
So what to do?
We have seen one solution, which is
government regulation of the industry.
There is another, which is to charge, or
tax, people for the harm they are
doing to others. This will “internalize
the externality.
Here is our
factory causing
$100,000 worth
of harm to the
people around the factory. It could cut
the pollution in half by spending
$25,000 on scrubbers. Will the owner
do it?
What if he had to pay $1 in taxes for
each $1 harm done by his pollution?
Some people have proposed a
“carbon tax” as part of the solution
to global warming.
Besides externalities, there is
another type of marked failure is
known as public goods.
Public Goods
A good for which the cost of
exclusion is prohibitive and for
which the marginal cost of an
additional user is zero.
For example, a streetlight placed
on a block.
Examples of Public Goods
1) Streetlights
2) Roads
3) National Defense
4) Light Houses
5) Free Television
The Free Rider Problem
Free Riders – People or firms that
consume a public good without
paying for it.
The government gets around the
problem by not asking you to pay,
but telling you to pay.
In theory, the government can
handle this problem. In practice,
we still have our old problems of:
1) information.
2) incentive.
Tragedy of the Commons - What
happens when property rights are
not assigned?
Once property rights are assigned,
problem solved. This is why the
cow population is thriving and
whales are hunted almost to
extinction.
The air is a commons.
Unless the government enforces
regulation or taxes.
Of course, we have talked about air
pollution before, under
externalities.
The tragedy of the commons isn’t
really a new thing, it is a subset of
externalities.
Who owns the air?
What we learned today.
1. The main types of market failure –
Externalities, public goods, and the
tragedy of the commons.
2. How the government can deal with
these problems – regulation and taxes.
Welcome to Day 18
Principles of
Microeconomics
What we learned yesterday.
1. The main types of market failure –
Externalities, public goods, and the
tragedy of the commons.
2. How the government can deal with
these problems – regulation and taxes.
Test Prep Day
Welcome to Day 19
Principles of
Microeconomics
Test Day